Burst of CLO refinancings expected ahead of Libor’s end

Managers of U.S. collateralized loan obligations may look to jam in more refinancings and related transactions by the end of this year, before the CLO and loan markets start switching to different benchmarks and potentially turn chaotic.

A lack of consensus regarding the eventual replacement for the London interbank offered rate could cause turbulence for CLOs in the fourth quarter, according Bank of America Corp. The benchmark is widely used across the sector and set to go away by June 2023 at the latest.

This could add even more steam to the boom in refinancings and “resets” of CLOs, which allow portfolio managers to lock in sweeter terms on outstanding deals. Combined total sales this year are about to cross $100 billion, according to data compiled by Bloomberg, the fastest pace ever as the tally builds to a likely annual record.

Libor transition is nothing new, but regulators have stated U.S. banks should end Libor origination “as soon as practicable” and no later than December 31 of this year. Libor will be retired for good in June 2023.

The absence of clarity regarding a replacement, as well as potential mismatches between the benchmarks used for CLOs and underlying leveraged loans, may cause CLO premiums to widen later this year. CLOs already suffer from basis risk with leveraged loans -- most leveraged loans are pegged to one-month Libor, while CLOs are priced off three-month Libor -- and the Libor-replacement discussion will only exacerbate it.

“To mitigate basis-risk mismatch in 2022 (between loans and CLOs), we expect most managers and equity investors to price, refinance, or reset transactions within 2021 itself,” BofA strategists Chris Flanagan, Pratik Gupta and Siddhant Mohanty wrote in a research note last week. “We believe this uncertainty could create some spread volatility in late 2021 as the market tries to reach a consensus.”

The preferred Libor replacement benchmark for CLOs and loans would be a forward-looking version of the Secured Overnight Financing Rate, known as term SOFR, but the Federal Reserve-convened Alternative Reference Rates Committee has indicated that more work needs to be done in order to recommend it. It might not be ready anytime soon.

Some other securitization sectors, such as commercial mortgage-backed debt sold by Freddie Mac, have already used average SOFR for some offerings. But that form of the benchmark may not be ideal for CLOs given the basis risk.

BofA maintains its forecast for $360 billion of CLO sales this year. That’s broken into $140 billion for new issues and $220 billion for combined refinancings and resets.

Resets for Octagon Credit, First Eagle Alternative Credit, and Wellfleet were among those that priced this week, while refinancings for Cerberus Loan Funding and Aegon were also completed.

Reset transactions differ from refinancings as issuers are able not only to reprice at a lower rate, but also may tweak various features of the existing CLO in different ways, including shortening maturities. CLOs typically last about four to five years before their managers sell the portfolio, pay the CLO bondholders and give the remaining cash to investors in the riskier equity part of the deals.

Even if term SOFR gains traction in the sector, it would require a so-called credit spread component that would need to be taken into consideration, BofA said. However, that credit spread would be fixed at pricing and as Covid-19 has demonstrated, “banks and other lenders are susceptible to a lot more variability in credit costs during stress periods.”

Therefore, a number of credit-sensitive rates are being considered as alternatives to Libor. The new benchmarks include Ameribor, ICE Benchmark Administration Ltd.’s ICE Bank Yield Index and Bloomberg’s Short-Term Bank Yield Index. BSBY is administered by Bloomberg Index Services Ltd., a subsidiary of Bloomberg LP, the parent of Bloomberg News.

Given the overall uncertainty and confusion around the potential benchmarks that will be discussed for the remainder of this year, it’s possible that there could be a short-term mismatch where loans and CLOs refer to different benchmarks in 2022, even though “ultimately we think they converge,” BofA said.

There also could be dispersion in preferences among the investor community for benchmarks: for example, U.S. banks may prefer a credit-sensitive rate, while some asset managers would prefer a rate tied to their repo costs.

Moreover, basis risk would be even higher than it normally is for new-issue CLOs that ramp up their assets in 2021. “Such CLOs would likely have predominantly Libor-linked loans and liabilities linked to another index,” the analysts wrote.

Lastly, in a rising rate environment, three-month Libor and one-month Libor basis has typically increased, causing volatility in CLO equity distributions.